Investors face two risks at retirement

Investing is a vital strategy for growing your retirement savings, but it comes with inherent risks. Financial markets are unpredictable and fluctuate daily. As a result, the value of your investments can rise and fall, and there is no guarantee of either the capital or returns on your investments. While no investment is entirely risk-free, being aware of these potential pitfalls associated with retirement savings allows for better planning and risk management strategies:

1. Investment risk

Investment risk refers to the possibility that the returns from your investment portfolio may be lower than expected. Factors such as market volatility, economic downturns, and poor performance of individual assets can contribute to this risk. When investment returns fall short of expectations, it can negatively affect your capital, reducing the amount available for retirement.

2. Sequence risk

Sequence risk is particularly relevant for investments intended to provide income during retirement. This risk arises from the timing of market volatility and withdrawals, especially just before or after retirement. During this period, your retirement capital is most vulnerable to the impacts of market downturns. Significant losses early in retirement can deplete your savings faster than expected, making it harder to recover and sustain your desired income level.

The ability to make withdrawals prior to retiring could potentially amplify sequence risk, as the timing of withdrawals from a fund can often have a significant impact on the final amount of capital that individuals have when they exit the fund at retirement.

In light of this, how do we ensure that the timing of withdrawals does not prevent investors from entering retirement with sufficient savings to support themselves?

Run-of-the-mill returns may fail to keep up with drawdown rates

One approach would be for investors to attempt to time their withdrawals to moments after the market has run, to limit the impact of withdrawing capital during a drawdown. However, it is difficult to time markets to any exact degree and individual financial emergencies are more likely to occur during periods of economic or market distress.

To protect their retirement savings over the long term, while still allowing for the possibility of an emergency withdrawal during the savings accumulation period, investors would need to hold a portfolio that delivers strong returns while minimising drawdown risk. Realistically, the standard South African balanced fund does not generally deliver this blend of characteristics.

Understanding the impact of sequence risk – The risk of timing your retirement badly

We have referred to the importance of minimising drawdown risk. However, market returns can range from exuberantly positive to dismally negative from one year to another, as the table below shows. This makes it difficult to minimise drawdown.

Table 1: SA asset class calendar year total returns (%) from 2015 to 2023

Source: Sanlam Investments, Morningstar Direct, 2024

Over the long term, investors who can stay in the market will be able to ‘absorb’ years of negative or stagnant returns by waiting for years of positive returns to make up for lost ground. However, investors who withdraw money during periods of market drawdowns may fail to realise their savings targets since they entered the good market years with less capital.

The year that you start your retirement savings journey and the timing of withdrawals can make a significant difference to your retirement capital. Two investors earning the same average return can see their capital behave very differently when they invest and/or disinvest at different times. This phenomenon is known as sequence risk. It is better illustrated in the example below.

Sequence risk: Case study

Table 2: Hypothetical annual returns by eight investors all earning 6% on average over 10 years

Source: Glacier Research, Sanlam Investments Multi-Manager, 2024

Let’s assume each of our eight investors is 10 years away from retirement, has R1,000 of retirement capital and contributes R5 every year until retirement. How much would their remaining capital be worth after 10 years if they all withdrew R200 from their retirement savings at the end of year two, considering the returns depicted above?

Chart 1: The impact of a different sequence of returns on investors’ capital

Source: Glacier Research, Sanlam Investments Multi-Manager, 2024

Dean, who had the strongest first few years of returns but negative and sub-inflation returns later in the 10-year period, ended up with the most capital at retirement. In comparison, Johann, who experienced negative returns in his first two years and excellent returns later in the 10-year period, reached retirement with the least amount of capital saved. Although both investors averaged a return of 6% per year over the full period, Dean’s more favourable sequence of returns allowed him to reach retirement with almost 14% more capital than Johann, despite both individuals having withdrawn the same amount, the same length of time before their retirement. The negative impact of sequence risk can be substantial.

Investors who needed to withdraw some of their savings at the end of 2018 would have had a real-world experience of Johann’s scenario. They would have needed much higher-than-average future returns after their withdrawal for their capital to make up for lost ground.

For a different view of how sequence risk works, we can look at what an investors savings journey can look like, using different scenarios of when they needed to withdraw capital.

Taking Johann’s return series as a starting point, let’s assume two scenarios where he needed to withdraw capital at the end of year two, rather than capital at the end of year nine.

Chart 2: The impact of different timing of withdrawal on investors’ capital

Source: Glacier Research, Sanlam Investments Multi-Manager, 2024

Under the year two withdrawal scenario, Johann withdrew capital while his savings were suffering a drawdown. Under the year nine withdrawal scenario, Johann withdrew capital after the market had experienced a strong run. Despite having withdrawn the same amount of money and experiencing the same returns, the difference in timing meant he reached retirement with substantially less capital under the less favourable year two withdrawal scenario.

But there’s hope: Tools to combat sequence risk

The standard balanced fund – in which most retirement savers are invested – cannot deliver large enough after-inflation returns over the long term while simultaneously minimising drawdown risk year-on-year (y/y). Fortunately, there are portfolio construction tools available that – to an extent – can mitigate against sequence risk in retirement. They aim to achieve an asymmetrical distribution of returns using the following strategies: 1) absolute return funds, 2) smooth bonus funds, and 3) alternative assets.

1. Absolute return funds ‘soften’ negative years

The first step to narrow the wide range of possible returns in a retirement fund is to choose a fund with an absolute return focus. The asymmetric nature of these funds means they capture less market downturns than conventional balanced funds, while aiming to still capture a decent amount of bull market runs. When an absolute return fund does what it says on the label, it reduces the sequence risk of a retiree’s portfolio by cutting off negative returns within the return distribution.

2. Smooth bonus funds create more income stability

A smooth bonus fund is another tool that can reduce volatility and sequence risk in a retirement savings portfolio. By holding back excess returns in good years and releasing them back to investors in years when markets perform poorly, these funds give investors a more stable return experience in the form of smooth bonus declarations on a y/y basis. This is an excellent tool in trying to achieve asymmetry in returns.

3. Alternative assets are there to boost returns

Even when smoothed, though, it’s a challenge to achieve the after-inflation return that retirement savers require to enable them to reach retirement with sufficient capital if they’ve had to make emergency withdrawals during their savings journey. A retirement portfolio therefore needs a third step – return boosters.

Fortunately, an arsenal of alternative assets can do this job: hedge funds, private equity, mezzanine debt, unlisted credit, and unlisted property, to name a few. These can generate higher returns from capital that is locked away for a certain period. Alternative strategies are used extensively in institutional investing, but due to accessibility issues they have not yet been offered to retail investors. We aim to change this, as these investments can form a crucial part of a solution that assists investors in reducing sequence risk.

The chart below shows how – using an absolute return fund, augmented with smooth bonus and alternatives funds – risk can be substantially reduced in a portfolio while still providing higher returns.

Chart 3: How our solution improves the investor’s risk-return experience

Source: Glacier Invest, Sanlam Investments Multi-Manager. Period: 09/2021-02/2024

To conclude, new thinking is required to solve the retirement savings problem for South Africans. It’s time to use the full range of appropriate portfolio construction tools available to reduce investors’ sequence risk, and provide a retirement savings solution that enables retirees to have sufficient income to preserve their lifestyles in retirement.